Marginal vs. Effective Income Tax Rates

by Michael on Feb 22, 2013

Photo of Calculator (Closeup)

Earlier this week, I met with our tax guy and picked up a copy of our now-completed income tax returns for review.

In looking through the numbers, I noticed something rather interesting.

Though our adjusted gross income (AGI) was similar between last year and this year, there was a somewhat odd divergence in our marginal and effective tax rates.

Note: In this case, I’m estimating our effective rate as our total (federal) tax bill divided by our taxable income (after exemptions and deductions) x 100%.

For 2012, we wound up in the 25% tax bracket but we paid an effective rate of 16.7%. This difference was due to a combination of factors including how tax brackets work, favorable rates on qualified dividends, and some tax credits.

In contrast, in 2011 we wound up in the 15% tax bracket thanks to some outsized deductions, but we paid an effective rate of 22.2%. In this case, the difference was largely due to getting hit with the alternative minimum tax (AMT).

I’m mainly putting this out there as a cautionary tale. Though they’re both important pieces of the taxation puzzle, your income level and even your tax bracket tell just a fraction of the story.

Two taxpayers with similar AGIs can wind up in very different tax brackets depending on the deatils of their situations, and those in a lower bracket can wind up paying a higher (effective) rate than those in higher brackets.

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